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Does inflation really drive gold prices? - Outside View by Asad Dossani
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Does inflation really drive gold prices?
Jul 25, 2011

The last couple of weeks have seen significant increases in the gold price, and prices rising to record highs. The gold price increases have come on continued fears about the US and EU debt crisis. Towards the end of the week, gold prices fell back a little, as fears have somewhat receded.

The most common argument in favor of holding investments in gold is that inflation will eat away the value of paper currencies, while gold will retain its value, as it cannot be printed. Last year, all the financial press was worried about runaway inflation due to the US Federal Reserve's quantitative easing (QE) policies.

Despite two rounds of QE by the Fed, US inflation was low last year, and remains low this year. The runaway inflation scenario has failed to materialize. On the other hand, gold continues to climb and has been one of the best performing assets in the last year.

Gold has also been performing well due to the EU debt crisis. Whenever there is news about Greece coming close to default, gold prices rise. There may be an inflationary argument here too. In theory, a default by a Eurozone country would spell trouble for the euro as a currency, and would reduce its value.

Yet this too has failed to materialize. Despite all the Eurozone woes and debt concerns, the euro's value today is higher than it was a year ago. We haven't had much in inflation in Europe either.

This leads us to question whether inflation is really the main driver of gold prices. Currency debasement and runaway inflation has been talked about a lot, but has not occurred. The gold price on the other hand has continued rising as if high inflation was taking place.

What then is driving the gold price Maybe it is driven by fears about inflation, rather than inflation itself. As financial markets tend to be forward looking, this is plausible if the market expects future inflation to be high. But if this is the case, we should expect to see a large fall in the gold price if inflation turns out to be low in the medium-term. This appears unlikely given the way markets are moving.

An alternative explanation is the gold isn't really driven by inflation at all. Gold certainly has a safe haven appeal to it, and investors are holding gold in case economies do badly or their other investments fall. In this scenario, whatever happens to inflation, gold will perform well simply because people believe that it is a good asset to hold when things go wrong.

This is certainly the way gold has been behaving recently. The threat of inflation has reduced, but the appeal for gold has only increased due to the debt woes of the US and the Eurozone.

Disclosure: I do not hold the currency/commodity discussed in this article.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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1 Responses to "Does inflation really drive gold prices?"

Ramanand

Jul 28, 2011

Artificially lowered rates of return on capital drives up the price of Gold. When Central Banks intervene in the economy by easy money policies, existing money holders (both big lenders and small savers) lose the ability to earn decent return on their capital. Also, low interest rates mean risk of them rising (can interest rates fall lower from 0 to 0.25%, which is currently given by the US FED?). Rising interest rates mean falling bond prices, hence the risk of putting money in bonds is very high in a low interest rate scenario. Hence, capital flocks to safer havens such as gold/precious metals/non-perishable commodities. As a trend of increasing prices gets established, technical factors favor continued money flow into these which keeps the momentum going.

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